Sept. 21 (Bloomberg) -- Yields on Fannie Mae and Freddie
Mac mortgage securities that guide U.S. home-loan rates tumbled
the most in more than two years relative to Treasuries after the
Federal Reserve said it will reinvest proceeds from past
purchases of housing debt into the bonds.

Fannie Mae’s current-coupon 30-year fixed-rate mortgage
securities fell about 0.16 percentage point to 1.06 percentage
point more than 10-year U.S. government debt as of 4:15 p.m. in
New York, the largest drop since March 2009, according to data
compiled by Bloomberg. That narrowing had followed the Fed’s
decision to increase its initial buying of agency mortgage
securities to $1.25 trillion from as much as $500 billion.

The Fed is switching tactics after previously reinvesting
into Treasuries the cash generated by its holdings of agency
mortgage securities and debt, as it sought to return to its
traditional assets.

The central bank, which bought more than $1.4 trillion of
housing debt through March 2010 to support the economy, plans to
apply principal payments toward new purchases of home-loan bonds
“to help support conditions in mortgage markets,” the Federal
Open Market Committee said today.

Fannie Mae and Freddie Mac mortgage bonds trading closest
to face value were soon “gapping tighter on the surprise,”
Walt Schmidt, a mortgage strategist in Chicago at FTN Financial,
said in a note to clients.

Treasury Purchases

The Fed also said today that it will buy $400 billion of
Treasuries with maturities of six to 30 years through June while
selling an equal amount of debt maturing in three years or less.

Yields on agency mortgage bonds have been guiding rates on
more than 90 percent of new U.S. home lending following the
collapse of the non-agency market in 2007 and a retreat by
banks. The $5.4 trillion market includes securities guaranteed
by government-supported Fannie Mae and Freddie Mac and bonds of
government-insured loans backed by federal agency Ginnie Mae.

The central bank has also absorbed debt from the more than
$2 trillion market of corporate borrowing by Fannie Mae, Freddie
Mac and the government-chartered Federal Home Loan Bank system.
It owned $885 billion of the mortgage bonds and $110 billion of
the agency debt as of Sept. 14, after buying $1.25 trillion and
$172 billion, according to Fed data.

The Fed’s portfolio of mortgage securities shrunk by about
$14.4 billion last month and is set to pay down by about $21
billion next month, according to BNP Paribas SA analyst
estimates. About $25 billion of the agency debt holdings will
mature over the next year, according to Nomura Securities
International Inc. analysts.

‘Dramatically Changed’

Today’s decision by the Fed means the “supply-demand
technicals have dramatically changed” for agency mortgage
bonds, the Nomura analysts led by Ohmsatya Ravi in New York
wrote in a note to clients.

Domestic money managers, including real estate investment
trusts, were poised to absorb about $390 billion to $400 billion
of the debt, assuming loan rates stay around 4 percent, they
said. With the Fed’s decision, the amount shrinks to $65 billion
to $70 billion, according to their estimates.

“Because the expectation had been that there would be a
gradual running down of the Fed’s balance sheet, and that’s not
in the cards, the mortgage market as you would expect is doing
very, very well,” Tad Rivelle, who oversees about $65 billion
as head of fixed-income investments at Los Angeles-based TCW
Group Inc., said in a telephone interview.

The average interest rate on a typical 30-year fixed loan
fell to an all-time low 4.09 percent last week, as Europe’s
sovereign debt crisis and a slowing U.S. economy drove investors
to benchmark Treasuries and government-backed debt, Freddie Mac
data show. The cost reached this year’s high of 5.05 percent in
February.